How dividend reinvestment plans work
When an investor enrolls in a dividend reinvestment plan, he will no longer receive dividends in the mail or directly deposited into his brokerage account. Instead, those dividends will be used to purchase additional shares of stock in the company that paid the dividend. There are several advantages to investing in DRIPs; they are:Benefits of enrolling in a dividend reinvestment plan
- Enrolling in a DRIP is easy. The paperwork (both online and in print) can normally be filled out in under one minute.
- Dividends are automatically reinvested. Once the investor has enrolled in a DRIP, the process becomes entirely automated and requires no more attention or monitoring.
- Many dividend reinvestment plans are often part of a direct stock purchase plan. If the investor holds at least one of his shares directly, he can have his checking or savings account automatically debited on a regular basis to purchase additional shares of stock.
- Purchases through dividend reinvestment programs are normally subject to little or no commission.
- Dividend reinvestment plans allow the investor to purchase fractional shares. Over decades, this can result in significantly more wealth in the investor’s hands.
- An investor can enroll only a limited number of shares in the dividend reinvestment plan and continue to receive cash dividends on the remaining shares.
Practical examples of dividend reinvestment plans in action
Full enrollment in a DRIP Jane Smith owns 1,000 shares of Coca-Cola. The stock currently trades at $50 per share and the annual dividend is $0.88 per share. The quarterly dividend has just been paid ($0.88 divided by 4 times a year = $0.22 per share quarterly dividend). Before she enrolled in Coca-Cola’s dividend reinvestment plan, Jane would normally receive a cash deposit of $220 in her brokerage account. This quarter, however, she logs into her brokerage account and finds she now has 1,004.40 shares of Coca-Cola. The $220 dividend that was normally paid to her was reinvested in whole and fractional shares of the company at $50 per share.Partial enrollment in a DRIP William Jones owns 500,000 shares of Altria group. The stock currently trades at $49.75 and pays an indicated annual dividend of $2.72 per share ($0.68 per quarter). William would like to receive some cash for living expenses but would like to enroll some of the shares in a DRIP. He calls his broker and has 300,000 shares enrolled in Altria’s DRIP.
When the quarterly dividend is paid, William will receive cash dividends of $136,000. He will also receive 4,100.50 additional shares of Altria Group giving him holdings of 304,100.50 shares (300,000 shares * $0.68 dividend = $204,000 divided by $49.75 per share price = 4,100.50 new shares of Altria Group).
Dividends on dividends
Why are dividend reinvestment plans conducive to wealth building? Notice that William now has 4,100.50 additional shares of Altria stock. When the next quarterly dividend is paid, he will receive $0.68 for each of those shares. That additional income works out to $2,788.34. Those dividends will be partially reinvested in the stock, buying more shares which will pay more dividends.In even the smallest portfolio, dividend reinvestment plans can result in substantial increases in value over extended periods of time. To demonstrate the power of dividend reinvestment through DRIPs, consider the example given in Jerry Edgerton and Jim Frederick’s August 1, 1997 Money magazine article, Build Your Wealth Drip by Drip: if you had put $10,000 in Standard & Poors 500 stock index at the end of 1985 and not bothered to reinvest your dividends, you would have had $29,150 by the end of 1995. Had you reinvested the dividends, however, your total would have been more than $40,000.
In other words, reinvesting those seemingly-small dividends resulted in an extra $10,850 over ten years. Assuming you continued to add to your principal investment and held those stocks for thirty or forty years, the difference could be hundreds of thousands of dollars or more.
